Capital Asset Pricing Under Heterogeneous Expectations And The Importance Of Restrictions On Short Sales

Research Paper (undergraduate) from the year 2007 in the subject Business economics - Investment and Finance, grade: 1,0, University of Applied Sciences Berlin, course: Financial Management, language: English, abstract: In everything you do, or don't do, there is a chance that something will happen that you didn't count on. Risk is the potential for unexpected things to happen. Risk aversion is a common thing among almost all investors. Investors generally dislike uncertainty or risk and agree that a safe dollar is worth more than a risky one. Therefore, investors will have to be persuaded to take higher risk by the offer of higher returns. In this investment context, the additional compensation for taking on higher risk is a higher rate of return.Every investment has a risk element: The investor will always not be certainwhether the investment will be able to generate the required income. The degree of risk defers from industry to industry but also from company to company. It is not possible to eliminate the investment risk altogether but to reduce is. Nevertheless, often there remains a risky part. According to the degree of risk, the investor demands a corresponding rate of return that is, of course, higher than the rate of return of risk-free investments. Taking on a risk should be paid off. The Capital Asset Pricing Model (CAPM) is an economic model for valuing stocks, securities, derivatives and/or assets by relating risk and expected rate of return. CAPM is based on the idea that investors demand additional expected return if they are asked to accept additional risk.

We study a dynamic equilibrium model with costly-to-short stocks and heterogeneous beliefs. The closed-form solution to the model shows that costly short sales drive a wedge between the valuation of assets that promise identical cash flows but are subject to different trading arrangements. Specifically, we show that the price of an asset is given by the risk-adjusted present value of future cash flows which include both dividends and an endogenous lending yield. This formula implies that returns satisfy a modified capital asset pricing model and sheds light on recent findings about the explanatory power of lending fees in the cross-section of returns. In particular, we show that once returns are appropriately adjusted for lending fees, stocks with low and high shorting costs offer similar risk-return tradeoffs.

Research Paper (undergraduate) from the year 2008 in the subject Business economics - Banking, Stock Exchanges, Insurance, Accounting, grade: 1,3, University of Cooperative Education, language: English, abstract: The objective of this paper is to give an overview of the most important movements of the complex area of asset pricing. This will be tried by logically structuring and building up the topic from its origins, the Capital Asset Pricing Model, and then over its main points of critique, in order to arrive at the different options developed by financial science that try to resolve those problematic aspects. Due to the complexity of this subject and the limited scope of this paper, obviously it will not be possible to discuss each model or movement in depth. Coherently, the aim is to point out the main thoughts of each aspect discussed. For further information, especially concerning the deeper mathematical backgrounds and derivations of the models, the author would like to refer the reader to the books mentioned in this paper. Many of those works, finance journal publications and the literature on asset pricing in general, set their focus on different parts of this paper, which again underlines the complexity in terms of scientific scope and intellectual and mathematical intricacy of this topic.

Research Paper (undergraduate) from the year 2008 in the subject Business economics - Banking, Stock Exchanges, Insurance, Accounting, grade: 1,3, University of Cooperative Education, 31 entries in the bibliography, language: English, abstract: The objective of this paper is to give an overview of the most important movements of the complex area of asset pricing. This will be tried by logically structuring and building up the topic from its origins, the Capital Asset Pricing Model, and then over its main points of critique, in order to arrive at the different options developed by financial science that try to resolve those problematic aspects. Due to the complexity of this subject and the limited scope of this paper, obviously it will not be possible to discuss each model or movement in depth. Coherently, the aim is to point out the main thoughts of each aspect discussed. For further information, especially concerning the deeper mathematical backgrounds and derivations of the models, the author would like to refer the reader to the books mentioned in this paper. Many of those works, finance journal publications and the literature on asset pricing in general, set their focus on different parts of this paper, which again underlines the complexity in terms of scientific scope and intellectual and mathematical intricacy of this topic.

Taken together, the Efficient Capital Markets Hypothesis (ECMH) and the Capital Asset Pricing Model (CAPM) appear to predict that the market price of a security in an efficient market should reflect the best possible estimate of its fundamental value. Although this notion once exercised great influence among both finance theorists and legal scholars, closer inspection reveals it to be tautological: because the CAPM rests on an assumption that all investors make identical estimates of securities' future risks and returns, it naturally predicts that market prices reflect that consensus. More recent work in finance examines what happens to securities prices when investors hold disagreeing expectations for the future. This quot;heterogeneous expectationsquot; literature offers to resolve a number of the mysteries that have plagued scholars who rely on the conventional ECMH/CAPM. In illustration, this paper presents a simple heterogeneous expectations pricing model premised on investor disagreement, risk aversion, and short sales restrictions. The model explains at least the following market puzzles: (1) why many investors don't diversify; (2) why target shareholders receive large premiums in corporate takeovers while bidding firms' share prices remain relatively unchanged; (3) why certain anomalous classes of securities, including neglected stocks, low P/E stocks, and low- beta stocks, offer superior risk-adjusted returns relative to the market; (4) why stock buyback programs and dividend payments support stock prices while stock issues depress market prices; and (5) how certain actively managed investment funds, Berkshire Hathaway chief among them, can consistently beat the market over long periods.

This book proposes a new capital asset pricing model dubbed the ZCAPM that outperforms other popular models in empirical tests using US stock returns. The ZCAPM is derived from Fischer Black’s well-known zero-beta CAPM, itself a more general form of the famous capital asset pricing model (CAPM) by 1990 Nobel Laureate William Sharpe and others. It is widely accepted that the CAPM has failed in its theoretical relation between market beta risk and average stock returns, as numerous studies have shown that it does not work in the real world with empirical stock return data. The upshot of the CAPM’s failure is that many new factors have been proposed by researchers. However, the number of factors proposed by authors has steadily increased into the hundreds over the past three decades. This new ZCAPM is a path-breaking asset pricing model that is shown to outperform popular models currently in practice in finance across different test assets and time periods. Since asset pricing is central to the field of finance, it can be broadly employed across many areas, including investment analysis, cost of equity analyses, valuation, corporate decision making, pension portfolio management, etc. The ZCAPM represents a revolution in finance that proves the CAPM as conceived by Sharpe and others is alive and well in a new form, and will certainly be of interest to academics, researchers, students, and professionals of finance, investing, and economics.

The problem addressed in this dissertation research was the inability of the single-factor capital asset pricing model (CAPM) to identify relevant risk factors that investors consider in forming their return expectations for investing in individual stocks. Identifying the appropriate risk factors is important for investment decision making and is pertinent to the formation of stocks' prices in the stock market. Therefore, the purpose of this study was to examine theoretical and empirical validity of the CAPM and to develop and test a multifactor model to address and resolve the empirical shortcomings of the single-factor CAPM. To verify the empirical validity of the standard CAPM and of the multifactor model, five hypotheses were developed and tested against historical monthly data for U.S. public companies. Testing the CAPM hypothesis revealed that the explanatory power of the overall stock market rate of return in explaining individual stock's expected rates of return is very weak, suggesting the existence of other risk factors. Testing of the other hypotheses verified that the implied volatility of the overall market as a systematic risk factor and the companies' size and financial leverage as nonsystematic risk factors are important in determining stock's expected returns and investors should consider these factors in their investment decisions. The findings of this research have important implications for social change. The outcome of this study can change the way individual and institutional investors as well as corporations make investment decisions and thus change the equilibrium prices in the stock market. These changes in turn could lead to significant changes in the resource allocation in the economy, in the economy's production capacity and production composition, and in the employment structure of the society.